Major political issue

Climate change and its consequences have been discussed again and again at the political level throughout the world, and during the last few years in particular. Every year, the participants of the annual UN climate change conference meet to discuss and negotiate international climate protection agreements.

The culmination of these endeavours was the entry into force of the Paris Climate Agreement (only available in German) in November 2016. In particular, the Agreement is aimed at limiting global warming caused by greenhouse gases to well below 2 degrees Celsius in future and is meant to initiate the final departure from the use of fossil fuels, i.e. coal, gas and oil.

The increased political importance is another reason why the issue has become a focus for institutional investors in recent years. Back in 1999, the then UN Secretary-General Kofi Annan emphasised the importance of businesses for environment protection in his speech at the World Economic Forum and launched the network "UN Global Compact" between business leaders and the United Nations. To this day, investors credit the UN with playing a key role in environment and climate protection.

Transformation risks

Undertakings that do not attach importance to sustainability expose themselves to risks. The departure from fossil fuels which was initiated at the latest with the signing of the Climate Agreement involves transformation risks which are also known as "stranded assets" or "the carbon bubble". The shift from carbon-intensive production to climate-friendly business segments may mean severe losses in value for gas, oil and coal producers and their investors.

In particular, investors with long-term strategies such as life insurance undertakings and pension funds should therefore know the risks involved if they add carbon-intensive investments to their portfolios.

Present regulatory framework

The increased importance of sustainability for institutional investors is also reflected in the regulatory framework already implemented by European and German legislation. At present, regulation of insurance undertakings and institutions for occupational retirement provision puts its main focus on the transparency requirements relating to sustainability aspects based on so-called ESG (environmental, social and governance) criteria.

For example, the European Parliament adopted a directive in 2014 which stipulates that certain large undertakings and groups must disclose non-financial and diversity information. The directive provides that, as of the financial year starting in 2017, the undertakings concerned are required to include in their group management report a statement containing information relating to non-financial key performance indicators, such as environmental aspects, to the extent necessary for an understanding of the undertaking's development or the group's position. The directive was transposed into national law under the provisions of section 315 (3) of the German Commercial Code (Handelsgesetzbuch - HGB - only available in German). Insurance undertakings subject to these provisions are required to include a non-financial statement in their group management report.

Environmental considerations

Life insurance undertakings that offer occupational retirement provision must, at the start of the pension contract, provide current and future beneficiaries who are not, at the same time, policyholders with information on how the provider takes account of environmental issues when using the contributions paid in. This information must be comprehensive and meaningful in accordance with section 144 (1) sentence 1 no. 1 f) and sentence 2 of the German Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG - only available in German).

Insurers that fall within the scope of Solvency II must also take account of the characteristics of the assets including sustainability in the regular review of their investment policy principles pursuant to Guideline 29 of the European Insurance and Occupational Pensions Authority (EIOPA) on System of Governance. Although insurers subject to Solvency II generally have freedom of investment, they must comply with the qualitative framework, i.e. the regulatory standards which are based on the prudent person principle. In this context, the undertakings are in particular required to take note of section 124 of the VAG and EIOPA Guidelines 27 to 35 on System of Governance.

IORP II Directive

In addition, Directive 2016/2341 on the activities and supervision of institutions for occupational retirement provision (IORPs) (IORP II Directive) entered into force in January 2017. Article 19(1) sentence 1b provides that the member states shall allow IORPs to take into account the potential long-term impact of investment decisions on environmental, social, and governance factors in accordance with the prudent person principle.

Moreover, article 30 of the Directive stipulates that the member states shall ensure that IORPs prepare and, at least every three years, review a written statement of their investment-policy principles. The member states must provide for this statement to contain details on how the investment policy of the IORP takes environmental, social and governance factors into account. They will have two years to transpose the Directive into national law.

Implementation of sustainability

Despite increased regulation, the term "sustainability" has not yet been clearly defined in legislation. Irrespective of this, industry-specific standards have been developed over the past years, which many investors use for judging an undertaking's implementation of sustainability. The Principles of Responsible Investment of the United Nations are widely used for this purpose. For the insurance industry the Principles for Sustainable Insurance are also relevant.

Insurers who take account of sustainability aspects in their investment decisions and, for example, acquire green bonds, can make use of various sustainable investment strategies. There is, for instance, the principle of exclusion, in which the investor explicitly decides not to invest in certain undertakings, countries or products. Insurers may also withdraw their investments in certain products, undertakings or countries, i.e. divest such assets, or they can draw up positive lists allowing investors to define their own sustainability criteria. Some undertakings use the different variations cumulatively.

"Best in Class"

Another method which is widely used in practice is the "best-in-class" approach. The essence of this approach is that, when choosing within investment categories, investors should invest in undertakings that give the most consideration to sustainability aspects in their industry.

The ongoing dialogue between BaFin and individual undertakings has also shown how insurers deal with sustainability issues in practice. In the third quarter of 2017, for example, several undertakings outlined in supervisory interviews with BaFin the level of importance of the ESG criteria in their current investments and described the often extensive processes to ensure the integration of sustainability criteria.

Recommendations of the FSB

There are various initiatives on sustainability issues at the European level as well. The Financial Stability Board FSB published a report in June this year which deals with climate-related financial disclosures (see BaFinJournal July 2017, only available in German). The report contains recommendations on how undertakings should disclose climate-related risks.

It recommends that undertakings should disclose information on how they identify, assess and manage climate-related risks and what measures they take to deal with such risks. This is to enable investors to better assess and compare the climate risks incurred by the undertakings in which they invest. The implementation of the recommendations of the task force that prepared the report are at the discretion of the undertakings.

Expert group on sustainable finance

The European Commission also established a high-level expert group on sustainable finance at the end of 2016. It is tasked with drawing up recommendations for an overarching and comprehensive EU strategy for sustainable investment.

The expert group published its first interim report this June, providing specific recommendations on how a sustainable financial system could be achieved. The report includes, among other things, recommendations for transparency requirements with regard to sustainability issues and the development of a uniform classification system for sustainable finance. Pages 33 to 36 contain a section dedicated to insurance undertakings and institutions for occupational retirement provision with direct reference to Solvency II.

The expert group also conducted an online survey, which was completed mid-September 2017. The comments received are to be incorporated into the group's final report, which is expected in December.